What is accretion/dilution in M&A?

Accretion or dilution measures whether an acquisition raises or lowers the buyer's earnings per share. I calculate pro forma EPS for the combined company and compare it to the buyer's standalone EPS. If it goes up, the deal is accretive; if it goes down, dilutive.

Pro forma net income starts with both companies' net income, adds after-tax synergies, then subtracts the after-tax cost of financing: interest on new debt, interest income lost on cash used, and extra depreciation and amortization from writing up the target's assets. The share count increases by any new shares issued to the target's shareholders.

A quick shortcut is to compare yields. The target's earnings yield is its net income divided by the purchase price. The cost of each funding source is after-tax interest for debt, the lost after-tax interest yield for cash, and the buyer's earnings yield, the inverse of its P/E, for stock. If the target's yield is above the weighted cost, the deal is accretive before synergies and write-ups. Accretion is not the same as value creation, though: a buyer can overpay and still show accretion by using cheap debt, so I also look at return on invested capital and intrinsic value.